no. 2/2012 corporate governance in banks: problems and remedies

No. 2/2012

47

CORPORATE GOVERNANCE IN BANKS: PROBLEMS AND REMEDIES *

Monika Marcinkowska

University of Lodz, Finance, Banking and Insurance Institute,

ul. Rewolucji 1905 r. nr 39, 90-214 Lodz, Poland

[email protected]

Abstract: Weak and ineffective corporate governance mechanisms in banks are pointed out as

the main factors contributing to the recent financial crisis. Deep changes in this area are

necessary to reinforce the financial sector stability. The paper presents key aspects requiring

reforms: the role, constitution and accountability of board, risk management, management

remuneration, transparency. New regulations and guidance are presented, creating the

foundations for a new order of the financial market. The paper also points out the banks’

stakeholders’ accountability.

Keywords: banks, corporate governance, financial sector regulations and reform, risk

management, board of directors accountability, directors remuneration, banks’ transparency.

JEL Classification: G34, G21, G28, G00.

Introduction

Each turmoil (and especially a crisis) in the financial markets brings a wave of re-adjustments

and re-regulations. After analysis of the causes of the problems the regulators seek to establish

new laws, which in their opinion will fix the system and make the supervision of the market

and its participants more effective in order to avoid a repetition of such difficulties.

The subprime financial crisis evidenced many problems specifically connected with

regulations and attitudes of many actors (in particular the financial sector). The main guilt for

the collapse of the financial markets was – not unduly – assigned to banks; the weakness and

inadequacy of the mechanisms of corporate governance in these institutions was indicated.

This paper aims to present the specificity of the corporate governance of banks and indicate

the main deficiencies in the bank governance system. The key goal of the paper is to describe

key aspects requiring reforms: the role, constitution and accountability of board of directors,

risk management function, management remuneration system, banks’ transparency; and to

present new regulations of the financial market.

The main research methods used in the paper are the review and critical analysis of literature

and study of the regulations; based on that, a method of logical deduction is applied; the

* The project was funded by the National Science Centre (Narodowe Centrum Nauki).

Financial Assets and Investing

48

analysis of numerical data presented (based on case studies retrieved from literature and

financial analysis of banks’ aggregate data) allow for an illustration of the issues discussed.

The specificity of the corporate governance of banks

A bank’s failure to follow good practices in corporate governance and the lack of effective

governance are among the most important internal factors which may endanger the solvency

of a bank.1

Corporate governance in banks differs from the standard (typical for other companies), which

is due to several issues2:

• banks are subject to special regulations and supervision by state agencies (monitoring

activities of the bank are therefore mirrored); supervision of banks is also exercised by

the purchasers of securities issued by banks and depositors ("market discipline",

"private monitoring");

• the bankruptcy of a bank raises social costs, which does not happen in the case of

other kinds of entities’ collapse; this affects the behavior of other banks and

regulators;

• regulations and measures of safety net substantially change the behavior of owners,

managers and customers of the banks; rules can be counterproductive, leading to

undesirable behaviour management (take increased risk) which expose well-being of

stakeholders of the bank (in particular the depositors and owners);

• between the bank and its clients there are fiduciary relationships raising additional

relationships and agency costs;

• problem principal-agent is more complex in banks, among others due to the

asymmetry of information not only between owners and managers, but also between

owners, borrowers, depositors, managers and supervisors;

• the number of parties with a stake in an institution’s activity complicates the

governance of financial institutions.

To sum up, depositors, shareholders and regulators are concerned with the robustness of

corporate governance mechanisms. The added regulatory dimension makes the analysis of

corporate governance of opaque banking firms more complex than in non-financial firms

(Wilson, Casu, Girardone, Molyneux, 2010).

In the case of banks therefore, corporate governance needs to be perceived as a need of such

conduct of an institution, which would force the management to protect the best interests of all

stakeholders and ensure responsible behaviour and attitudes (Tirole, 2001). Corporate fairness,

1 The issue of bank bankruptcy is discussed in detail in: D.T. Llewellyn (2002), W.R. Miller (1996, January), Office of the Comptroller of the Currency (2001, January). 2 For further discussion read: D.T. Llewellyn (2002), M. Marcinkowska (2009) P. Cincanelli, J.A. Reyes-Gonzalez (2000, June), B.E. Gup (2007), R. Adams, H. Mehran (2003, April).

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transparency and accountability are thus the main objectives of corporate governance, taking

into account the corporate "democracy", which is the broad participation of stakeholders (R.E.

Basinger et al., 2005)3.

One must have in mind that there is no one model of corporate governance adaptable to all

banks. Other goals, and therefore supervisory systems, will be in banks: private, cooperative

and state; in the local and global banks; universal banks and investment (etc.); though

priorities remain the same.

In the banking sector corporate governance is therefore a way of business and affairs of the

bank by the management and the board, affecting how they (BCBS, 2006, February):

• define the objectives and goals;

• lead current bank activities;

• fulfill the obligation of accountability to shareholders and take into account the

interests of stakeholders;

• apply the requirement to operate safely and to ensure a good financial situation and

compliance with applicable regulations;

• protect the interests of depositors (and other clients and creditors).

Shortcomings in the governance of large financial groups have indicated that these may trigger

(indirectly) systemic risks. Regulators and financial supervisors take action to ensure an

individual bank’s stability; in the case of systemically important banks this would result in the

pursuit of overall financial stability. The main issues of corporate governance matters with

specific systemic impact are: the “gatekeepers” (esp. auditors and credit rating agencies),

corporate values and codes of conduct of banks, risk management and internal governance of

banks managerial incentives to act in an appropriate manner, accounting (and valuation) rules

(E. Wymeersch, 2008, October).

Moreover, there is some scepticism about the effectiveness of the ‘comply or explain’

approach to corporate governance (FRC, 2011 December). Analysis of the statements on the

application of corporate governance indicates that a vast majority of companies did not present

an explanation of the reasons to withdraw from the application of certain rules or the

clarification is made with low quality information. This confirms the need for support

mechanisms employed by the regulator and the requirement that companies monitor

statements made by the regulator and take an appropriate response to the lack of or insufficient

explanation (D. Seidl, P. Sanderson, J. Roberts, 2012).

As pointed out by the European Commission, the "comply or explain" approach would work

much more effectively if specific monitoring bodies (such as regulatory bodies for securities,

3 The rights of stakeholders and active collaboration with them are also emphasized in the principles of OECD - OECD (2004) Principles of Corporate Governance. It is even emphasized that balancing the interests of all stakeholders positively affects the stability of banks, eliminating (or reducing) potential conflicts - K. Zalega (2003, July).


50

stock exchanges or other bodies) were entitled to check whether the available information (in

particular the explanation) has an appropriate informative value and is appropriately broad. It

is emphasized, however, that these institutions should not interfere with the content of the

information disclosed or evaluate the solutions adopted by the company – it should still be a

task left to the market (EC 2011, April 5).

Key areas of failure of corporate governance in banks

The confidence of the public (in a bank and the entire banking system) is necessary for a

proper functioning of the financial system and economy. Effective corporate governance

practices are fundamental to gain and maintain this confidence (BCBS 2006, February). As the

recent Edelman “trust barometer” study shows, banks and financial services are the two least

trusted industry sectors (for the second year in a row)4.

Trust is a basic prerequisite for a proper functioning of banks, therefore it is necessary to carry

out fundamental reforms that will bring inner harmony and allow the recovery of the public

trust. Therefore, an in-depth analysis of the recent crisis causes should be done. Particularly

considering that the rules of proper conduct of banking business exist and are being

implemented, but it is mainly the deficiencies in corporate governance which are to blame for

the recent financial crisis5. This raises the question: Were the rules inadequate or poorly

implemented?

Analyses of the causes of the crisis lead to indicate several issues requiring a re-structuring

and strengthening of standards; these issues concern (Kirkpatrick, 2009, September, A. Turner,

2009, March, D.Walker, 2009, November 26):

• the role, tasks and responsibilities of the board, as well as its size, organization and

composition (members) and the functioning of this body and the assessment of its

work;

• control of bank risk exposure;

• evaluation of executives and its incentive pay;

• transparency of the bank supervisory board that allows for the assessment of its

activities (both by institutional and private monitoring);

• ownership structure of banks and the role of institutional investors.

In order to avoid a similar financial crisis in the future, regulators of financial markets are

planning to establish standards for sealing the system in these areas.

4 Authors comment that the financial meltdown throughout the Euro Zone has had a particularly negative impact on trust and the persisting negative economic climate is going to make the recovery of trust in that region even more difficult in 2012. Edelman (2012, January 19) 5 It should be however stressed that an analysis performed by Adams (for the period 1996–2007) showed that the governance of financial firms is, on average, not obviously worse than in non-financial firms. See: R. Adams (2009, April).

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The board of directors

The board of directors is the first level of supervision over the activities of the bank and its

management. The board is ultimately responsible for the activities and results of the bank, for

the maintenance of stability and financial soundness. The powers and rules of the board are

specified in the law and the statute of a bank. The mode of operation should be specified in the

rules of procedure of the board.

The core competences of the board forming the foundations of the bank activities include:

approving and overseeing the strategic objectives of the bank and its corporate values,

overseeing the work of the management board and the determination of the scope of the

obligations and liability of the management members, the establishment of guidelines for the

acceptable level of risk, overseeing the introduction of the management system (consisting at

least of the system of risk management and internal control system), and assessment of the

adequacy and effectiveness of the system.

If these tasks are to be performed, certain conditions concerning the organization of the

council and its members must be duly met. In this first issue the question of the creation and

functioning of the committees of the board should be taken into account in particular.

The Polish good practice (Dobre praktyki…, 2011) recommends that the Supervisory Board

has at least the Audit Committee (it should include at least one member of the independent).

Large European banks typically create committees: audit, remuneration, nomination, risk; in

rare cases also: strategy, social responsibility, credit, mediation, quality, technology, etc.

(Nestor Advisors 2008). In the case of banks it is currently postulated that they should form

the risk committees, since it is mainly insufficient supervision of this area which is the most

visible imperfection preventing bank governance.

There are a number of requirements for members of the supervisory board of a bank. An

absolute requirement is that they have high qualifications, clearly understand their role in the

supervision of the bank and are able to assess the matter in a balanced manner. This is the first

rule of effective corporate governance in banks, published by the Basel Committee on Banking

Supervision (BCBS, 2006, February). It is therefore necessary to ensure that the board of the

bank consists of persons with great professionalism6 (adequate direction of knowledge, skills,

commitment, experience), constantly upgrading their skills.

As presented in Figure 1, the percentage of chairs of the board with financial industry

expertise within the 25 largest European banks is slowly decreasing (while the overall figure

of percentage of non-executive directors with financial industry expertise is increasing, but the

average figure is much lower – about 30%; at the same time the maximum percentage is also

decreasing). This means almost 2/3 of the chairs of banks boards have previously held

6 For more on professionalism in the functioning of supervisory boards: JeŜak J. (2005).


52

executive positions in banks or other financial institutions. The frightening fact is that in some

boards none of the non-executive directors has financial industry expertise.

Fig. 1 Financial industry expertise of chairs of the board (25 largest European banks)

0%

20%

40%

60%

80%

2007 2008 2009 2010

Financial industry expertise

Chairpersons who areformer CEOs of the samebank

Chairpersons who areformer CEOs of a differentbank

Chairpersons who areformer banking executives

Source: Nestor Advisors (2010)

Members of the board must be able to spend enough time performing their tasks (which is not

limited to participation in the meetings of the board and its committees).7 It is important that

members of the board should perform their duties with engagement, but it is not recommended

that they take part in the current (operational) management (BCBS, 2006, February).

It is necessary to keep formal rigorous assessments of the board and its members, and the

report of the assessment should be available (some codes of governance are explicitly the

requirement for such assessments at least once a year). This is to ensure that the board (and its

individual members) fulfils its task due, and it includes the persons characterized by

professionalism, meeting the specific requirements of the supervised company.

Another matter of corporate governance, of essential importance, is the membership of the

independent persons in the council8. The Polish good practice recommends that at least two

members of the supervisory board meet the criteria of independence (whatever the overall size

of the board9). Their participation in the board is to objectify its work, to provide care to the

board in the first instance of the fortunes of the company (and not just its owners), as well as a

balance between the interests of the dominant shareholders and minority shareholders. Figure

7 Attention is drawn to the fact that the directors should devote their duties related to the supervised company much more time than now. See: Walker (2009). 8 The profile of independent director is for example described in the Commission Recommendation of 15 February 2005. 9 Some codes of corporate governance suggest a percentage of independent board members (eg. the British Combined Code – 50%).

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2 illustrates the trends in the independence of non-executive directors in the largest European

banks.

Fig. 2 Percentage of independent non-executive directors (25 largest European banks)

0%

20%

40%

60%

80%

100%

2007 2008 2009 2010

max

average

min

Source: Nestor Advisors (2010)

Control of the risk incurred by the bank

Risk is the inherent feature of bank’s activities; bank management is indeed risk management.

Proper management of the risks incurred by the bank provides for its survival on the market

and financial success. Regulations impose standards limiting the bank risk and requiring

adequate equipment in the capital to absorb losses due to materialization of this risk.

In addition, recommendations and standards provide guidance for the banks concerning the

main stages of the process of risk management: identification, measurement, control and

monitoring. Peculiarities of the development of markets and financial instruments cause that

those first are not able to take account of all the details and options, quite quickly become

outdated and do not correspond to reality.

Banks led by the desire for profits can easily use the gaps in legislation and expose themselves

to risks without incurring regulatory consequences. However, if the bank inadequately

calculates its capital needs, and the supervisory bodies are not able to catch it early and

discipline the bank to take appropriate action, it could threaten the solvency of that entity and

cause its bankruptcy.

Figure 3 pictures the trend in the evolution of the average proportion of equity to assets of U.S.

commercial banks during the last 160 years, indicating a dramatic decline in the importance of

equity in the financing of the bank. Given that the most important function of capital in banks

is the stabilization and loss absorption, this shows the huge growth of risk over the years.


54

Fig. 3 The average equity/total assets ratio in US commercial banks

1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

60

50

40

30

20

10

0

%

Source: based on Tarullo (2008) and Bank of England (2009)

Figure 4 illustrates the recent history – on the example of the largest 100 banks from OECD

countries it shows the increase in financial leverage (understood as a relationship of off-

balance sheet assets and liabilities to equity) and the growing importance of off-balance sheet

items in banks.

Fig. 4 The average leverage ratio and off-balance sheet /total assets ratio in top 100 OECD banks

0

5

10

15

20

25

30

35

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Ass

ets

and

off

-bal

ance

sh

eet

acti

viti

es /

eq

uit

y

0%

5%

10%

15%

20%

25%

Off

-bal

ance

sh

eet ac

tivi

ties

/to

tal

asse

ts

total leverage (left scale)

off-balance sheet/total assets (right scale)

Source: author’s own work based on BankScope database

Both figures document the increased risk generated by the banks; other important indicators

showing the same trend are: the growth of loans/deposits ratio, increase in loan loss

provisions/net interest ratio (and the worsening of other ratios describing loans quality and the

scale of provisioning), the growth of exposures to central banks, etc.

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Risk management is a very difficult process; often it is emphasized that it is more art than

science. Risk management in banking is all the more difficult as it is magnified by the domino

effect (contagion effect). The stability of a bank is influenced by the situation of the other

actors of the sector; decline in confidence in one of the banks often results in a decrease in

trust in all financial institutions. Ensuring appropriate policies, processes and infrastructure of

risk management is therefore fundamental to the bank survival. Effective risk management is

based on good corporate governance and rigorous internal control (W. J. McDonough, 2002).

The role of the supervisory board is more important; its task is, among others - monitoring of

implementation and adequacy of the operation of the system of management (including risk

management) and the establishment of strategic objectives (including an acceptable level of

risk). This means determining the optimal level of risk (in the context of the adopted strategy,

conditions created by the environment of the bank, current and projected financial situation

and their resources, including capital and skills, the available contingency plans) and

monitoring of the current risk in relation to that level. It is necessary in this area to cooperate

and use the work of external and internal auditors of the bank and the internal control function.

Excessive risks taken by banks and the use of complex financial instruments which in fact

transfer the risk (and this is often not fully recognized by the buyers of those instruments) were

the direct causes of the bankruptcy of many banks and spread of the financial crisis.

Supervisory bodies have responded with the proposal to strengthen prudential standards –

“Basel III” framework has been adopted, which tightened the definition of capital, introduced

counter-cyclical capital buffers and introduced liquidity standards (BCBS 2010, December a;

BCBS 2010, December b; BCBS 2011, June)10.

Currently the guidelines are being formulated, aiming to strengthen the functions of risk

management in banks. First of all, it is emphasized that the establishment of the policy

management of risk (including the determination of an acceptable level of risk) is one of the

main duties of the supervisory board. In banking environment there is full agreement as to the

validity of this principle. However in practice it turns out that while the board indeed

establishes the policies and priorities for risk management, the risk awareness and risk

management awareness are not widespread in the organization (which is read as weak

corporate governance)11, and reports about the risks are not always appropriate or available to

the board (G. Kirkpatrick, 2009, September).

10 There are essential changes in capital requirements (including the capital buffers and dynamic provisioning), liquidity risk measurements standards and a system of supervision of financial markets (including the establishment of institutions responsible for the control of systemic risk). For further discussion see: M. Marcinkowska, 2009a and M. Marcinkowska, 2009b. 11 The vast majority of surveyed councils of large European banks only "rather had knowledge" of the risk measurement methodologies (with a small percentage of responses "was very knowledgeable") - Nestor Advisors, 2008.


56

Among the recommendations there is the suggestion that in (the large listed) banks the risk

committee should work12 regardless of the audit committee. Such a committee would oversee

the actual risk exposure of the bank and advise the board on the strategy of risk management.

This committee should cooperate on a regular basis with a member of the board of

management responsible for risk (Chief Risk Officer) and external experts in the field of

analysis and risk assessment.

It is also recommended to the board (or the risk committee) to draw up a report on the risk,

which would constitute a part of the annual report of a bank (D.Walker, 2009, November 26).

It is worth noting the excessive confidence in mathematical models for measuring risk. These

models are simplified descriptions of reality and are based on many assumptions, which may

reduce their effectiveness in predicting future states. Although the risk measurement methods

are improved, we cannot rely solely on an analysis of numbers; risk management, management

of the bank, must be based on a prudent subjective assessment (the result of the numerical

methods yields only the basis for the assessment made by a human being).

The remuneration of bank managers

The task of the supervisory board is to ensure that the system of remuneration of the bank

management was consistent with its corporate culture, its long term objectives and strategy

and environment control (BCBS, 2006, February). It is difficult to deny the validity of this

principle (formulated by BCBS). However, it is the issue of remuneration of the bank

management that is indicated as one of the fundamental problems of corporate governance and

is pointed out as one of these irregularities which led to the financial crisis.

The level of remuneration in banks has substantially grown in the recent years. The example of

average New York City salaries (Figure 5) shows that in the record year 2007 the average pay

in securities industry (mainly banks) was over 520% higher than the average for all other

private sectors. The bank executives’ pay is growing even faster.

The inadequacy of the mechanisms of corporate governance in this area largely stems from the

short time horizon in which results of the companies (including banks) are assessed and from

the pressure to generate a high return on equity (which requires banks to generate high profits).

Impatience and greed of investors was therefore the key factor provoking banks to more

aggressive financial behaviors (the greed of banks and bankers blamed by the media was only

an indirect consequence). Not without significance is also the practice of making the managers

into owners of their banks (through the payment of wages in the form of stocks or stock

options) designed to motivate managements to take a greater care of the owners’ interests; the

effect was achieved in multiple ways.

12 Currently there is such a committee in less than half of Europe's largest banks.

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57

Fig. 5 Average salaries in New York City (US$)

0

50 000

100 000

150 000

200 000

250 000

300 000

350 000

400 000

450 000

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2010

securities industry

all other private sector

Source: based on Rampell (2011)

The structure of CEOs remuneration can stimulate excessive risk taking – if the bonuses are

tight with the short term results (e.g. one year profits or profitability ratios), the managers are

willing to concentrate on generating higher returns (even at one-time events) and tend to

neglect the risk. Although the total remuneration of bank CEOs has been decreasing since the

financial crisis, the short term bonuses still play an important role in many banks (see Figure

6).

Fig. 6. Structure of remuneration of largest European banks’ CEOs (fiscal year 2009)

0%

20%

40%

60%

80%

100%

selected largest European banks

otherincome

long-termincentives

annaulbonus

salary

Source: based on Nestor Advisors (2010)

The boards of the banks – willing to generate high profits in the shortest possible time – take

excessive risks. Studies have confirmed that excessive risk taking (and treating risk more as a

possibility of achieving profits than losses) is stimulated by an application of higher premiums


58

and financial objectives for the management (K. Bechmann, J. Raaballe, 2009, September and

F. Harman, S. Slapnicar, 2007).

Therefore, some recommendations concerning principles for remuneration of the managers are formulated, constituting that13:

• there is a need to link items to incentive targets, the owners and the long-term

profitability of the bank, while taking into account the level of risk and cost of capital;

• components of the special incentive arrangements should not lead to bearing risk

exceeding the acceptable level,

• payout of compensation incentives should be based on risk-adjusted and cost of

capital-adjusted profit and phased, where possible, to coincide with the risk time

horizon of such profit14;

• bonuses should include an element reflecting the impact of the results of the business

unit for a total value of the related business groups and entire organizations;

• bonuses should include an element reflecting the accumulated results of achievement

in the field of risk management and other overall objectives;

• severance payment should take into account the results achieved for owners in the

horizon of time;

• strategy, principles and objectives of the incentive pay should be transparent for

owners.

The broader recommendations relating to the whole system of remuneration in the bank are

raised. The remuneration committee should be familiar with the conditions of employment and

remuneration applied by the bank, to ensure that it is implementing a consistent approach to

remuneration of all staff. It is recommended that the supervision of wage policy exercised by

the committee of the council is extended to all the best paid employees (and that the evaluation

of the relationship with the objectives concerning the results and risk is taken into account); it

is also suggested that large quoted banks disclose the remuneration of such employees (as is

the case for members of management). It is also stipulated that the banks have a deferred

payment of the premium that includes a mechanism for corrections of risks so as to provide for

sustainable results. It is necessary to ensure that the system and structure of remuneration does

not encourage the wrong bank exposure to risk – remuneration policy must be consistent with

effective risk management (A. Turner, 2009, March, D.Walker, 2009, November 26)15. The

remuneration policy should be transparent inside the bank and disclosed outside (CEBS, 2009,

April 20).

13 IIF (2008, July). Final report to the IIF Committee on Market Best Practices: Principles Conduct and Best Practice Recommendations, Washington. 14 This recommendation is implemented the least; some institutions do not plan to include it at all (IIF, 2009, March). 15 Those recommendations are already included in guidelines of some regulators, e.g.: FSA (2009, August) and EU (Commission Recommendation of 30 April 2009).

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Bank transparency

Bank transparency has several aspects. The most important is the question of transparency in

the activities of the bank and its management and the issue of transparency (and

understandability) of reports on the activities of the bank and its results. The question of

transparency of the activities of the bank is to a considerable extent linked with its established

organizational structure. If complex structures (e.g. enhanced capital group and special

purpose entities — SPV) are implemented, the responsibility is blurred, transferring income,

cost and risk is easier. Similar effects can be caused by an implementation of matrix structures

in related banks. This limits the powers of the management structure for a subsidiary bank

(decisions are taken by the heads of the divisions at the central level, this means full

dependence on the owner) and makes it more difficult for an overall evaluation of the risk of

individual participants of such a holding company.

Non-transparent structures give rise to additional risk (financial, legal, or reputation) and

impede adequate control and supervision (in particular with regard to separated and outsourced

areas and matrix dependence). The bank therefore strives to ensure clarity of structures and

links, to gain a complete picture of the results and the risks incurred by the bank (as a whole

and the individual divisions/units).

The second issue of the transparency of a bank is openness and transparency of information

about its financial health. This is a basic condition for the functioning of effective market

discipline, which is the private monitoring carried out by the purchasers of the securities

issued by the bank (as well as by clients). Market discipline means that the entity has

stakeholders from the private sector, who may suffer a financial loss as a result of the decision

of that body, and who can "discipline" bank or affect its activities (FRS Study Group on

Disclosure, 2000, March).

The existence of an effective market discipline is dependent on several factors, the most

important are: the existence of well-developed securities markets, bank issuance of

subordinate debt securities or other hybrid securities in the market, access to reliable,

complete, up-to-date information about the profile of risk borne by the bank (and proper

understanding of the information provided by the bank), the presence of response to market

signals16.

Regulators - recognizing the potential role of the bank private monitoring - strengthen this

pillar of surveillance by establishing more stringent information requirements on banks. In

developed economies, there is indeed evidence of the effectiveness of the discipline of the

market in the risk assessment of the bank (and motivate banks to limit the risk undertaken).

However, during the last financial crisis, the market discipline has suffered a defeat (A.

Turner, 2009, March). The prices of financial instruments issued by banks (in particular shares

16 More about market discipline: K. Jackowicz (2004).


60

and CDSs) did not reflect the risks incurred by these institutions and did not announce

upcoming problems (and their scale). Where to find the causes? The answer lies in several

areas (Marcinkowska, 2008):

• First, the criticism is aimed to the accounting standards (whatever their orientation:

principle-based – as in IFRS or rules-based – as in US GAAP); however, it should be

acknowledged that the legislation in certain areas (such as securitization) does not

prevent the hidden risks of investment; the issue of accounting for financial

instruments is also controversial;

• banks ignored information requirements, intentionally obscuring the facts picturing

their financial situation (in particular the nature and level of risks incurred);

• the independent entities having assessments of banks and issuing of securities under

the securitisation failed (auditors and rating agencies17);

• investors were not aware of the risks incurred, in part due to the aforementioned

reasons, but partly these losses were the result of overly aggressive investment

policies and a lack of the good practices of risk management.

In many cases, the regulatory gaps have already been closed, but it should be noted that

particularly in this area good regulations do not ensure success. This is dependent on the

integrity and accuracy of all the parties involved in the process (especially the persons

responsible for the preparation and verification of reports, but also their customers –persons

taking the decisions on the basis of those statements).

Banks’ shareholders

Inefficiencies in corporate governance are often associated with the specific structures and

organizational or capital links (where the banks are part of large conglomerates, especially

where members of a group mutually own their shares). The financial dependence (e.g. granting

loans or buying bonds) may be based on inadequate risk analysis, which consequently

increases the risk for the whole group.

In relation to the subprime crisis, one can indicate that an important reason for its occurrence

was the fragmentation of the shareholders of financial institutions (which blurs the

responsibility of the owners for the fortunes of the company and increases the strength of the

management executives), as well as the presence of the cross-dependencies (which has

enlarged and spread the crisis) and aggressive, geared for quick profits, investment policy of

funds and other – usually short-term – investors (M.Marcinkowska, 2009a).

Given the large – sometimes negative – role of institutional investors, special

recommendations for this specific group of shareholders are formulated, relating to the

responsibility, integrity, diligence, dignity, fair competition, activities for the development of

17 After the subprime crisis, regulations concerning the activities of credit rating agencies were introduced.

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the market ant preventing conflicts of interest. Many of these recommendations were also

included in the cited Walker Review, as rightly noted that the activities and results of the banks

are affected – directly or indirectly, actively or passively – by initiatives and decisions taken

by the owners. The responsibilities of both the board and the institutional investors are set out,

as well as the need for cooperation and engaged cooperation.

During the recent financial crisis many banks were nationalized. Although in a short term this

was seen as a good solution to help the troubled banks (especially given the scale of problems

and the potential threat to the financial sector stability), it should be noted that in the longer

term state ownership should be repealed. Research supports bank privatization – private-

owned banks are more efficient (J. Williams, N. Nguyen, 2005).

Enhancing corporate governance in banks – what has been done so far

These issues have become the subject of numerous decision-making bodies, part of the above

issues have been addressed in the new regulations and guidelines, in relation to many other

processes creating new legislation is still in progress.

Among the global guidelines further initiatives are set by the Basel Committee. Banking

Supervision should be indicated. First of all, sectoral "good practices" must be indicated,

taking into account the specificities of the banks. General rules intended to improve corporate

governance in banks were updated by BCBS in October 2010. The current version of the

document contains 14 rules in 6 areas (BCBS, 2010, October):

• supervisory board practices,

• senior management,

• risk management and internal control,

• compensation policy,

• complex or opaque corporate structures,

• disclosure of information and transparency.

An extension of these documents is guidelines for the internal audit function in banks (BCBS,

2011, December) that formulate 20 rules relating to the issue: supervisory expectations relative

to the internal audit function, a function for internal audit of the institution of the supervisory

board, the supervisory assessment of the internal audit function.

Also the issue of remuneration of the top executives of banks was included in the Basel

guidelines – the document formulates principles for remuneration and methodology for

standards assessment (BCBS, 2010, January).

In addition, the ongoing work must be indicated: some new regulations have already been

developed and implemented.

As soon as in February 2009, the Group of experts chaired by Jacques de Larosière

recommended creating a European system of financial supervision (The de Larosière Group


62

Report, 2009). In September 2009 a new supervisory architecture was proposed (which has

been operating since January 2011): the European System of Financial Supervisors (ESFS),

consisting of regulators operating in the EU: banks (European Banking Authority), insurance

companies and pension funds (European Insurance and Occupational Pensions Authority) and

stock exchanges (European Securities and Markets Authority); an additional element of this

design is the European Systemic Risk Board18.

Among the new regulations first the initiative of the European Union should be mentioned: in

June 2010, the EU published a "green paper", referring to the issue of corporate governance in

banks and their policies of incentive compensation of management (European Commission,

2010, June 2 b). This document summarizes areas of inefficiency and failures of corporate

governance in banks (they are included in the list mentioned above), indicates the already

taken pre-legislative initiatives, and for consultation - options for further measures. They

concern, among others: accountability, independence and competence of the supervisory

board, strengthening risk management and status of the chief risk officer, the introduction of a

requirement for reporting by the auditor to the supervisory board and banking supervisory

institution, information on the observed significant risk, strengthening of banking supervision,

broader engagement of bank shareholders and exercise of effective control, as well as

remuneration issues of management and a conflict of interests. The Green Paper is

accompanied by a working document presenting good practices in the areas: the supervisory

board, risk management, owners, supervisors and external auditors (European Commission,

2010, June 2 a).

Earlier - already in 2009 - the Commission issued a recommendation on remuneration policies

in the financial sector (Commission Recommendation of 30 April 2009). The general

requirement is acceptance by banks of such remuneration policy which will promote sound

and effective risk management and will not encourage excessive risk, and at the same time,

will support the implementation of business strategy and reduce conflict of interests. In

particular, specific guidance with regard to policy formulation of the variable component of

remuneration is provided.

In addition, the European Commission has developed new arrangements, the essential purpose

of which is to increase the effectiveness of risk management in European credit institutions,

which should help prevent excessive risk taking by individual banks, and as a result of

cumulating excessive risk in the financial system. The new legal framework has three

operational objectives (European Commission, 2011, July 20):

• increasing the effectiveness of the board of supervision over risk;

• raising the status of the risk management function; and

• ensuring effective monitoring of the risk management by supervisory authorities.

18 See more: http://ec.europa.eu/internal_market/finances/committees/index_en.htm.

No. 2/2012

63

Upon the wave of criticism against the regulations relating to capital adequacy there was the

revision of the guidelines (the "Basel II"), the BCBS developed some requirements and

introduced the additional standards in this area – the “Basel III” (BCBS, 2010, December a, BCBS, 2010, December b, BCBS, 2011, June).

Basel guidelines are the basis for the creation or revision of the regulations under the European

Union. The European Banking Authority published the guidelines on the management system

of the institution and the internal control in September 2011 (EBA, 2011, September).

Conclusion

The scale irregularities found in banks and financial markets that led to the financial crisis

have brought up the need for in-depth analysis of all aspects of their operation, in particular

the efficiency of corporate governance. The result was an indication of a number of

shortcomings; sometimes they resulted from inadequacy or insufficiency of the provisions,

other times from human imperfections. Currently, regulatory and supervisory institutions and

environmental bodies prepare proposals for reforms to strengthen the mechanisms of corporate

governance.

The analysis of main failures of corporate governance in banks suggests that in order to repair

and strengthen the system:

− banks ought to reduce their risk exposure significantly, build a stronger capital base; banks

should concentrate on typical banking activities and reduce the scale of other operations

(especially investment activities); the good standards of balance-sheet adequacy (ALM)

should be restored (e.g. loans-deposits relationship, assets and liabilities maturity match,

leverage scale, etc.);

− the scale and scope of banking activities should be diminished, as the current level of

financialization is excessive and potentially dangerous for the whole economy; special

attention should be paid to systemic risk: systemically important banks ought to have

more strict capital requirements (additional capital buffer); the capital and contractual

relationships between financial institutions should be monitored and if the linkages would

become too strong and/or concentrated, supervisors should be allowed to interfere in these

relationships;

− bank directors (both: executive and non-executive) should bear personal responsibility for

banks’ activities and risk;

− banks’ executives remuneration should be linked to performance and risk exposure; there

should be an obligation to use part of their salary deferred: a) not to motivate to generate

short-term profits and increase the risk and b) make the bonuses contingent on long-term

sustainable outcomes;

− non-executive directors engagement should be stronger – they should devote more time

and commitment to perform their oversight function; nomination of supervisory board

members should be approved by the supervisors (as it is in case of management board


64

members); the role of independent board members should be strengthened, board

members should be required to have proper knowledge and experience (including the

financial expertise);

− regulators and market supervisors should strengthen banks’ transparency allowing for the

effective market discipline; professional bodies should promote best practice in disclosure

and motivate banks to publish more informative reports;

− the accountability of external and internal auditors should be stronger and they should be

obliged to report any observed non-compliance to supervisors; the auditors should be

subject to mandatory rotation and should be banned from performing services for one

client of other services beyond the audit of financial statements;

− “comply or explain” rule used in corporate governance area, being a sort of a “soft law”

should be strengthened by the monitoring function performed by financial market and the

supervisor should verify whether the disclosed information is reliable and sufficient;

− in particularly important areas in which banks persistently do not comply with corporate

governance best practices, supervision should make formally binding rules; one should

keep in mind, however, that this should not lead to excessive growth of regulation because

it would harm the competition (overly restrictive regulation can lead to inefficient

provision or supply of financial services).

Without doubt, the greatest responsibility for the excessive risks is borne by the banks

themselves – their management and supervisory directors. However, it is worth noting that

other stakeholders also contributed to the crisis: supervisors and regulators, participants in

financial markets (including investors), auditors and rating agencies, and clients. Obviously,

legal, economic and ethical issues differentiate the degree of responsibility and the magnitude

(severity) of the effects of the acts or omissions of several operators.

Regardless of the regulatory changes, it is necessary to emphasize the importance of

accountability of all banks’ stakeholders. One must realize that there are no perfect

regulations, and even the best legal standards do not ensure success. This is because it is the

attitude and actions of human beings; honesty and sense of responsibility of all stakeholders of

the bank are necessary.

As mentioned, governance – particularly in the banking sector – should ensure the care of the

well-being of all its stakeholders. This corporate fairness, transparency and accountability

must be symmetric.

As it is nowadays emphasized, there is also no doubt that the basic element of the improved

governance of the financial market should be ethics (EC, 2010). It is unrealistic to expect that

the supervision and private monitoring of complex financial markets and institutions may be

based solely on regulations, but this neither means that the state may exempt from these

processes. An effective regulatory regime must be based on a desire to keep high management

standards and values as part of banks’ corporate culture (R. Tomasic, 2011).

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65

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DOI: 10.5817/FAI2012-2-4

no. 2/2012 corporate governance in banks: problems and remedies

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